Rating Victims Didn’t Know S&P’s Toxic AAA Born of Greed

A file photo shows former Citigroup Inc. Chief Executive Officer Charles O. Prince III listening to a discussion at the World Economic Forum in Davos, during January 2005. Photographer: Daniel Acker/Bloomberg

Feb. 11 (Bloomberg) -- When Charles O. Prince III was chief
executive officer of Citigroup Inc. from 2003 to 2007, he didn’t
know about a surge in mortgage risk that his own investment
bankers loaded on to its bank’s books.

Because such debt carried top credit ratings from firms
such as Standard & Poor’s, few financial executives paid
attention to the potential dangers.

“If someone had elevated to my level that we were putting,
on a $2 trillion balance sheet, $40 billion of AAA rated, zero
risk paper, that would not in any way have excited my
attention,” Prince told the Financial Crisis Inquiry
Commission, according to a transcript of his testimony released
in 2011.

Mortgage securities granted top grades started souring in
2007, leading to ballooning losses. Citigroup required a $45
billion federal rescue, the largest of the bank bailouts that
put taxpayer money at risk. The Justice Department sued New
York-based S&P and parent McGraw-Hill Cos. last week over the
damage caused by the practices allegedly behind the inflated
rankings that contributed to the biggest financial crisis since
the Great Depression.

Some of the biggest losers were banks, including Citigroup
and Bank of America Corp., which created and purchased
collateralized debt obligations. Many of these investments --
created by packaging mortgage-backed bonds, derivatives and
other CDOs and dividing them into new securities with varying
degrees of risk -- imploded within a year after they were sold,
even though they had pristine credit ratings.

Buffett’s Bank

Smaller financial institutions were also ruined by
mortgage-backed debt. Western Federal Corporate Credit Union
failed after its executives employed an improperly “aggressive
investment strategy” that had no limits on highly rated
mortgage bonds, according to a regulatory report on its
collapse.

Even Warren Buffett was affected. The Justice Department
case identified Buffalo, New York-based M&T Bank Corp., whose
shareholders include Buffett’s Berkshire Hathaway Inc., as one
of the buyers of failed CDOs. Berkshire of Omaha, Nebraska, is
also the biggest shareholder of Moody’s Corp., owner of the
second-largest ratings firm after S&P.

S&L Law

The world’s leading financial institutions suffered more
than $2.1 trillion of writedowns and losses after soaring U.S.
mortgage defaults caused the credit crunch.

In the complaint filed Feb. 4 in U.S. District Court in Los
Angeles, the Justice Department is invoking a law created in
response to the savings-and-loan crisis of the 1980s that was
designed to offer easier victories when damage has been done to
institutions with federally insured deposits.

Success is “far from clear,” Jeffrey Manns, an associate
professor at George Washington University Law School, said Feb.
7 in a telephone interview. S&P may argue it believed in its
ratings or the statute doesn’t apply to the case.

“We start with proposition that we deny there was any
fraud,” Floyd Abrams, the Cahill Gordon & Reindel LLP lawyer
for S&P who represented the New York Times in the 1971 Pentagon
Papers case, said in a telephone interview on Feb. 7. Fraud
claims have “a high burden of proof,” he said.

Ed Sweeney, a spokesman at S&P, declined further comment.

Shares Slide

McGraw-Hill’s market capitalization, which reached a five-year high of $16.2 billion at the start of the month, has
plunged since the company said it anticipated the lawsuit would
be filed, reaching $11.9 billion at the end of last week.

The company’s stock price declined 27 percent in the five-day period ended Feb. 8 to $42.67, the biggest weekly drop in
data compiled by Bloomberg going back to August 1980. The yield
on its 2017 bonds leapt 69 basis points to 2.69 percent. The
cost of insuring its debt against non-payment through five-year
credit-default swaps jumped 135 basis points to 225.5 basis
points, according to data provider CMA. McGraw-Hill owns CMA,
which compiles prices quoted by dealers in the private
market.

Citigroup underwrote at least eight of the 12 CDOs from
2007 named in the government’s complaint for which it’s listed
as a victim. That included Bonifacius, an issue among the last
of its type named for a general called the “last of the
Romans” by historian Edward Gibbon because he fought and died
for a fading empire.

Prince, who was forced out over New York-based Citigroup’s
mortgage losses, didn’t return an e-mail last week.

Different Departments

Charlotte, North Carolina-based Bank of America, the
second-largest U.S. lender by assets, hired S&P to grade two of
the three CDOs for which it’s named as a victim, including one
overseen by Bear Stearns Cos.’s Ralph Cioffi, the manager of two
hedge funds whose collapse in June 2007 signaled the end of the
boom in mortgage-tied CDOs. Bear Stearns collapsed in 2008 and
was bought by JPMorgan Chase & Co., the largest U.S. bank, with
assistance from the Federal Reserve.

Underwriters of CDOs typically signed off on the contents
of the deals and the nature of disclosures regarding their risk.
Pressure from such firms pushed S&P to weaken its standards and
to put off changes in ratings methods that could have made it
tougher to receive top rankings, the Justice Department said.

Even though the Justice Department lawsuit relies on
examples where the same banks sold and bought their own toxic
securities, saying they were harmed by S&P “isn’t a totally
ridiculous assertion,” said Bert Ely, an Alexandria, Virginia-based bank consultant.

Big Organizations

“One of the things you’ve got to realize about large
financial institutions is that they’re big organizations,
they’ve got lots of different departments,” he said in a
telephone interview. “So the left thumb doesn’t know what the
right finger is doing, much less the right big toe.”

While no bank or regulator should have had a “blind
reliance on ratings,” the correct, lower grades might have
prevented risks from building, Thomas Stanton, a former senior
staff member at the financial crisis commission, or FCIC, said
Feb. 7 in a telephone interview.

“If we were in an era where rating agencies were simply
incompetent and the investors failed to do due diligence, that’s
one thing,” said Stanton, a Washington attorney and fellow at
Johns Hopkins University’s Center for the Study of American
Government. “But what seems to be coming out is a potentially
higher level of culpability at S&P.”

Federal Allegations

Federal prosecutors allege that S&P didn’t adjust its
analytical models or take other steps it knew were necessary to
reflect the risks of the securities. The claims are tied to
whether the company accurately represented the care it took in
providing credit grades and avoiding conflicts, not how
incorrect its ratings later proved. E-mails and other internal
documents show executives were concerned that tougher standards
would cause issuers to take their business elsewhere.

High ratings were critical to encouraging banks to invest
in mortgage securities, Chris Whalen, executive vice president
at Carrington Investment Services LLC, said Feb. 7 in a
telephone interview.

“A bank could not have bought the securities but for the
rating” said Whalen, a former managing director at
Institutional Risk Analytics, which evaluates banks for
investors. That’s because their capital rules “were totally
ratings driven.”

Credit Unions

Western Corporate Federal Credit Union, or WesCorp, was
seized by its regulator in 2009 after almost $7 billion in
losses from investments in mortgage bonds with AAA or AA
ratings.

Like other so-called corporate credit unions that provide
services to credit unions that deal with consumers, it was
“only allowed to invest in highly rated securities,” according
to a regulatory report on its failure.

While the Justice Department called San Dimas, California-based WesCorp a victim of S&P, the National Credit Union
Administration said in 2010 in a lawsuit against 15 of its
former directors and officers that they had been “grossly
negligent” in overseeing the bank. There had also been improper
payments from certain executive retention plans, according to
the lawsuit filed in federal court in Los Angeles.

Robert A. Siravo, its former CEO, agreed to pay $600,000
and was banned from working at credit unions to settle NCUA
claims, the regulator said in October. He didn’t admit liability
or fault.

Other Victims

Credit unions now pay special assessments to cover the
losses on failures of institutions including WesCorp. Those
costs may translate to lower savings rates to consumers.

Other victims named by the Justice Department included
Eastern Financial Florida Credit Union, which was created for
Eastern Airline Transport Co. employees and their family members
in 1937 and failed in 2009. Also identified were units of M&T
Bank, the lender that repaid more than $700 million in Troubled
Asset Relief Program, or TARP, funds in 2011, and Chicago-area
First Midwest Bancorp Inc.

The Financial Institutions Reform, Recovery, and
Enforcement Act of 1989 that the Justice Department is using to
sue S&P stemmed from the savings-and-loan crisis of the 1980s,
when the failure of about 750 thrifts cost taxpayers almost $90
billion.

“Firrea was the Dodd-Frank of its day,” Cliff Rossi,
executive-in-residence at the University of Maryland’s Robert H.
Smith School of Business, said Feb. 7 in a telephone interview,
referring to the financial-overhaul law enacted in 2010.

Tougher Enforcement

Because Citigroup and Bank of America created some of the
CDOs, Rossi said he “found it a little surprising they would
try to come at it like these were some unfortunately aggrieved
institutions.” Still, the history of why Firrea included
tougher enforcement powers reflected the view at the time that
thrift executives had often worked with other parties to put
their own firms and, ultimately, taxpayers at risk, he said.

“A lot of what happened had had nothing to do with looking
after the best interest of shareholders and instead about
looking after the best interest of senior executives,” Rossi
said.

The FCIC, which was created by Congress with a 10-member
bipartisan board in 2009, said in its final report that
Citigroup’s “willingness to use” its bank “to support the CDO
business had the desired effect” of boosting it from the 14th
ranked underwriter in 2003 to second place in 2007.

Bubble Bursts

In a 2008 letter to Vikram Pandit, Prince’s successor, the
Federal Reserve Bank of New York criticized how Citigroup
offered its various units “largely unchallenged access to the
balance sheet to pursue revenue growth.” Pandit was ousted in
October by Citigroup directors.

In turn, “what was good for Citigroup’s investment bank
was also lucrative for its investment bankers,” the FCIC said.
The co-heads of its global CDO business each made about $6
million in 2006, while a co-CEO of the investment bank earned
more than $34 million in salary and bonus.

Taxpayers were forced to offer the bank the $45 billion
bailout, later repaid, as part of the $700 billion TARP.

“I know it sounds like the bank robber who gets held up by
someone else,” said Ely, the banking consultant. “But bad guys
can still be victims of a crime.”

The case is U.S. v. McGraw-Hill, 13-00779, U.S. District
Court, Central District of California (Los Angeles).